US corporate tax reform: stock market implications (i)

The headline rate for US federal tax on corporate profits is 35%. That’s higher than just about anyplace else on the planet and, in itself, a deterrent to business formation in the United States. It’s also the reason for the big business of advising corporations on how to finesse the tax code that has sprung up over the past decade or so. In addition, it’s also why tax havens such as Ireland, Switzerland, Hong Kong and assorted islands in the Atlantic Ocean have become so popular with Americans.

A generation ago, world stock markets paid particular attention the rate at which a given company paid corporate tax. The assumption back then, which has turned out to be incorrect, was that a firm could only sustain a low tax rate for a limited period of time. So no matter what the rate shown in the financial statements, professional securities analysts would “normalize” it to the top marginal rate. Portfolio managers wouldn’t pay a full price for a low tax payer, either.

Not so in today’s world. As far as I can see, Wall Street has long since stopped believing that the “quality” of earnings taxed at below the statutory tax rate is less than those same earnings taxed at a higher one.

Trump’s proposed reform

Given that the Republican party controls both houses of Congress and the presidency, it seems to me that the corporate tax reform championed by Donald Trump has a good chance for becoming law. This would mean that for a company having $100 in fully-taxed pretax US income, after-tax profit would rise from $65 to $85–a 30+% boost.

big stock market implications

A change like this would have enormous implications for US-traded stocks. In particular:

–investor interest would rotate toward purely domestic companies. This would favor mid- and small-caps over large, and dollar earners over multinationals. I think this is already starting to happen

–to the degree that they could be, elaborate tax avoidance schemes that have become common for US firms will be unwound. Tax havens will suffer. On the other hand, profits from future earnings that would otherwise be held in tax-haven banks will begin to be repatriated to the US. Trump is also proposing to allow money now “trapped” in tax havens to be brought back to the US on payment of a 10% income tax.

–tax inversions by US-based companies–that is, flight of high-rate US taxpayers to tax havens abroad (or, actually, just about anywhere else) will come to a halt. Arguably, companies that have recently inverted may begin to trade at discounts to un-inverted peers

–the price US firms would be willing to pay for foreign companies using funds parked abroad should fall

–it’s possible that US investors will begin to become interested once again in the ins and outs of the tax line on the income statement. That might mean that 1980-style quality-of-earnings differentials will be in vogue again

–there are also possible negative implications for firms that have substantial tax loss carryforwards or who benefit from the many industry-specific tax preferences of the current tax code.